The Risk Trade, the Fed, and the Trap Door

Since the Greenspan Put became the Bernanke Put, and now has apparently morphed into the Universal Put, the markets have become a one-way bet. Those who got in last year, and stayed in, were richly rewarded. Those who let the headline risk get to them missed out.

The evidence is everywhere that the Fed’s goal of forcing investors out along the risk curve is taking hold. “Cash poured into U.S. stock funds at a blistering pace in the latest week,” Dow Jones’ Alex Scaggs and Pat McGee wrote, “as investors flocked into equities after a year-long rally and an early-January jump.”

The Dow sits just about 5% away from its all-time high. Junk bond prices are soaring and yields are plunging as investors give short shrift to the risks. Small-cap stocks and non-dividend stocks, the riskier part of the equities landscape, outperformed blue-chips last year.

Yes, bonds did well, too.

This is what Merrill Lynch strategist Michael Hartnett and others call the “Great Rotation,” and this year it looks to be finally hitting home. “On a scale of 0 for max bearish to +10 for max bullish we would guess investment sentiment toward equity markets is currently around +8 to +9,” he wrote in his “Thundering Word” note.

If the risk-at-any-cost mindset reaches into the heart of the bond market, the Fed’s victory will be complete. Bond investors are paying a sharp price for their desired safety, as yields dwindle, and gleeful bulls are predicting this year will finally be the year bond investors throw in the towel.

That’s usually just about the time that the bottom falls out.

Esther George, the president of the Kansas City Fed and this year a voting member on the Fed’s rate-setting committee, the FOMC, delivered a speech yesterday in Kansas City in which she specifically addressed the Fed’s role in skewing investor attitudes, and the possible consequences:

A long period of unusually low interest rates is changing investors’ behavior and is reshaping the products and the asset mix of financial institutions. Investors of all profiles are driven to reach for yield, which can create financial distortions if risk is masked or imperfectly measured, and can encourage risks to concentrate in unexpected corners of the economy and financial system. Companies and financial institutions, such as insurance companies and pension funds, and individual savers who traditionally invest in long-term safe assets, are facing challenges earning reasonable returns, and so they may reach for yield by taking on more risk and reallocating resources to earn higher returns. The push toward increased risk-taking is the intention of such policy, but the longer-term consequences are not well understood.

Of course, identifying financial imbalances, asset bubbles or looming crises is inherently difficult, as policymakers were painfully reminded during the financial crisis in 2008. Public transcripts of the FOMC’s discussions from as early as 2006 show participants were clearly focused on issues in the housing market and yet did not fully appreciate the risk to the economy from the financial sector’s exposure to risky mortgages.

Accordingly, I approach policy decisions with a healthy dose of humility when considering the long-run effects of monetary policy. We must not ignore the possibility that the low-interest rate policy may be creating incentives that lead to future financial imbalances. Prices of assets such as bonds, agricultural land, and high-yield and leveraged loans are at historically high levels. A sharp correction in asset prices could be destabilizing and cause employment to swing away from its full-employment level and inflation to decline to uncomfortably low levels.

Simply stated, financial stability is an essential component in achieving our longer-run goals for employment and stable growth in the economy and warrants our most serious attention.

Traders, speculators, the quants, and even the retailers finally lured into this risk trade are all betting the same thing: the Fed (and the ECB, and the BofJ, and the BofE, and the Swiss National Bank for that matter) won’t let them down. Further, most investors think they’re closer to the exit than the trap door, because the game here will be getting out first.

Everybody’s getting onto the same side of this massive, Fed-driven risk trade. At some point, it will become top-heavy and tumble. It is inevitable. The only thing we don’t know is the trigger and the timing.

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